In the world of Personal Finance, “diversifying your portfolio” forms part of the basics of investing. Diversifying your portfolio is only the first step, however. To effectively manage risk you have to rebalance your portfolio periodically to maintain the diversification benefits. Let me explain why:

There are three main benefits to rebalancing.

Let’s suppose that you have decided to diversify your portfolio by dividing it between 5 different sectors: Technology, Industrials, Pharmaceuticals, Banks and Oil.

For your pharmaceutical position, you have picked a highly speculative company that is in the process of conducting clinical trials. The trials can either be successful and multiply the value of the company or prove dangerous and make your shares worthless. Let’s suppose they are successful and the company quadruples in value. Your pharmaceutical stock now makes up 50% of your portfolio.

The problem is that the pharmaceutical company is still high risk. When you decided on the allocation, you knew that 20% of your portfolio would be at risk if things were to go wrong with the company. Now, 50% of your portfolio is at risk. The overall risk of the portfolio is now much higher. If you rebalance back to the 20% allocation, you will control the overall risk in your portfolio, which is the first benefit of rebalancing.

When you rebalance, you sell positions that have gains and buy positions that have losses to get back to the allocation that you chose. This forces you to sell high and buy low– the essence of making money in the stock market. This is the second benefit of rebalancing.

The third benefit of rebalancing is that it maintains your desired sector exposures. Let’s say you don’t rebalance and your oil company does well. It now comprises 33% of your overall portfolio. A third or your portfolio is now vulnerable to the price of oil dropping, where you only wanted 20% of your portfolio to be at risk. Rebalancing would have kept your risk to the level desired.

Rebalancing does have costs, however. Every time you trade there will be transaction costs and normally taxes that have to be paid on capital gains. To control costs you have to decide on when and how often to rebalance.

In my next post I will talk about two rebalancing methods: “calendar” rebalancing and “percentage-of-portfolio” rebalancing and their benefits and disadvantages.